The market may be expecting a UK base rate rise in May or August 2011 but I am not so sure.

The BoE Governor Mervyn King made it plain in his Newcastle speech that the disposable income of UK consumers is going to be squeezed by higher VAT, higher food & petrol prices and utility bills going up because they are linked to RPI.  The Governor also highlighted during his speech that the MPC is allowed to let inflation deviate from its target because of ”the remit given to the MPC which states that ‘the actual inflation rate will on occasions depart from its target as a result of shocks and disturbances. Attempts to keep inflation at the inflation target in these circumstances may cause undesirable volatility in output’. The MPC has stuck to its remit”.  In plain English, the BoE is not going to jack up interest rates and cause a double-dip recession just because commodity price rises have driven CPI up.

Add to this public sector workers losing their jobs and transferring to jobs in the private sector (if they are lucky), coupled with the fact that average pay in the private sector is actually lower than public sector pay, will result in a squeeze to incomes as ex-public sector workers have to take a pay cut to find a new job.

The current spike in UK inflation (CPI of 3.7% at the end of 2010) is mostly due to increasing commodity prices leading to more expensive food, fuel and raw materials for businesses.  The Bank of England cannot control the price of oil, wheat, steel or any other globally traded commodity so therefore raising interest rates to counter inflation caused by higher commodity prices will not lower UK inflation.  It will simply cause consumers yet more misery by raising their mortgage payments.

The cure for high commodity prices is high commodity prices. We have not yet started the spring crop planting season in Europe and farmers seeing high wheat prices should be encouraged to plant more wheat in response.

Companies are free to raise the prices of their products but the current weak state of the UK economy and weak position of the UK consumer means in practise that sales volumes may well decline as consumers either cannot afford more expensive goods or choose to spend the same amount of money each month buying fewer of them.  The UK is not in the situation where product prices are rising because of high consumer demand (which can be crimped by base rate rises).  Sensible investors should avoid retailers in 2011, utilities are a safer bet.

The Bank of England’s MPC is likely to carry on ignoring high CPI numbers caused mainly by increased commodity prices and instead watch like a hawk for so-called second round effects, namely to see whether workers manage to secure higher pay rises to offset their declining living standards – dream on, big pay rises are going to be rarer than rocking horse pooh for the average worker this year.  One sentence from the Governor’s Newcastle speech is worth repeating: “Further rises in world commodity and energy prices cannot be ruled out, and attempts to resist their implications for real take-home pay by pushing up wages would require a response by the MPC”.  The implication is clear, no big wage rises in 2011 means base rates stay at 0.5%.